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LONDON (Reuters) - Mergers and acquisitions in Europe are on the rise as investors regain confidence and that should provide a further fillip to equities, particularly in small and mid-sized firms.

As fears of a euro zone collapse recede, companies are increasingly looking to use cash stored up during the gloomier years to increase earnings, not least by buying rivals that have proved their strength by surviving the financial crisis.

In December, the combined value of European deals worth less than $500 million (317 million pounds) hit $21.1 billion, the highest since June 2011, Thomson Reuters data showed. Larger deals, meanwhile, totalled $141.8 billion, the highest since March 2008.

"There is usually a good correlation between share prices, valuation and deal activity, so (a) rising M&A trend tends to coincide with stronger equity markets," Jonathan Stubbs, European equity strategist at Citi, said.

But with small and medium-sized companies the target for 97 percent of all M&A deals done in Europe since 1990, at an average premium paid of 25 percent, JPMorgan data showed, indexes of smaller firms are well placed to benefit.

"Small companies relative to large companies would be the trade that I would put on from a macro perspective," Orrin Sharp-Pierson, global equity and derivatives strategist at BNP Paribas, said.

BNP Paribas analysts highlighted Swiss speciality chemicals maker Clariant (CLN.VX), German genetic testing specialist Qiagen (QGEN.DE), and Italian aerospace and defence group Finmeccanica (SIFI.MI), all of which are small or midcaps, as among possible acquisition targets.

Strong gains for bourses across the region since last summer demonstrated the market's "new-found confidence", Sharp-Pierson added. "You combine that with massive amounts of cash on the sidelines <held by> very large corporates... there's definitely the potential for an interesting year for M&A."

During the financial crisis firms who could amassed cash as a safety buffer but are now seeking to put it to good use.

The Euro STOXX 50 index .STOXX50E of euro zone blue chips has jumped around 33 percent from a June 2012 trough, with the rally triggered by a European Central Bank promise to defend the euro, while the STOXX Europe Small 200 .SCXP and the midcap equivalent .MCXP are both up some 25 percent over the period.

The rally might have hoisted valuations up from their lows, but they are still well off recent highs, with those for European small caps around a third below a peak hit in 2009 -- which should ensure the deal-making trend continues.

Typically, M&A activity lags by a few months gains in equity markets, which are quicker to price in an improved funding environment, stronger balance sheets and greater confidence in the economy.

All of which bodes well for event-driven hedge funds - which include those focusing on M&A - after a strong December in which they took joint top spot for the best performing strategy, Eurekahedge data showed.

In making acquisitions, firms are led by factors similar to those watched by equity investors, wanting to be confident that their target's share price will not collapse after the purchases and that it can generate growth.

The crisis years have also, arguably, sifted out some of the weaker names - as seen with recent collapses of British high street chains HMV, Jessops and Blockbuster UK - and left a pool of the stronger players for any would-be buyers to choose from.

"If you ever want to see a business being road-tested for quality, the last five years have been as testing an environment as you could wish to put a business through," said Paras Anand, head of European equities at Fidelity Worldwide Investment, which manages 148.7 billion pounds of assets.

"Therefore you should arguably be prepared to pay a fuller multiple at this point in time," he added, which would in turn give a fresh boost to valuations elsewhere in the target company's sector.

As well as putting a floor under stock valuations and fostering growth expectations, the ECB pledge capped fears that a deal in euros would see value eroded in the near future through a break-up of the currency bloc.

"If you're a corporate buyer and you're looking to do some M&A in a company that has a subsidiary in Italy, then you're going to want to know what currency you're buying into in the long term," Nick Williams, head of international small caps at Baring, said.

Williams pointed to Italian asset manager Azimut (AZMT.MI) as a potentially attractive takeover target, highlighting that it is a company that is growing in a market that is shrinking, so "it is doing something right in a weak environment".

"That greater confidence in the longer-term outlook for the stability of the euro is a big positive for M&A activity picking up," said the fund manager, whose firm has 32 billion pounds of assets under management.